Section 6. Obligations with a Penal Clause

PRINCIPAL AND ACCESSORY OBLIGATIONS

1. Principal Obligation - stands by itself and does not rely on another obligation.

2. Accessory Obligations - attached to a principal obligation, which cannot stand alone.

Obligation with Penal Clause - An obligation with an accessory to undertake the former stipulated indemnity, in replacement for the initial principal prestation in case of breach.

Penal Clause - is an accessory attached to an obligation to undertake the stipulated indemnity which holds a greater liability in case of breach, in which case the obligation is not complied with, or is partially performed in irregularity.

• The purpose of the penal clause is:

1. An assurance to performing the obligation which is deters the underperforming or breach; resulting in greater consequences thereof;

2. Payment of interest or substitute of penalty for damages as assurance; and

3. A consequence for non-compliance

• The Obligation with penal clause is strictly construed - according to the contract agreement

CONDITIONAL, ALTERNATIVE, FACULTATIVE

1. obligation with the penal clause - when there is a principal obligation with an accessory obligation attached to it. The debtor is not obliged to pay the penalty when he performs, unless the creditor demands unaffected by the existing penal clause.

2. conditional obligation - when the existence of the obligation is uncertain, a suspensive condition activates the effectivity of the obligation of the penal clause. If the condition did not happen, the obligation is extinguished.

3. alternative obligation - there is only one obligation, but there are two things that the debtor can choose to comply with. Upon compliance, the obligation is satisfied and is extinguished.

4. facultative obligation -  the debtor can choose to satisfy the obligation by substituting another in place of the principal obligation.

Kinds of Penal Clause

1. As to its origin:

   1. Legal Penal clause - provided by the law; and

   2. Conventional penal clause - as stipulated by  the parties.

2. As to its purpose:

   1. Compensatory penal clause - the penalty takes place of the damages; and

   2. Punitive penal clause - imposed as punishment for breach.

3. As to its dependability or effect:

   1. Subsidiary or alternative penal clause - only the penalty can be enforced; and

   2. Joint or cumulative penal clause - both the principal obligation and penal clause can be enforced.

Liability for penalty, damages, and/or interests

1. Penalty substitutes for damages and interests. - In case of non-compliance, whether or not there is proof of actual damages, the interest and payment for damages are substituted by the penalty, as per the rule, in obligation with a penal clause.

2. Penalty and interest enforceable. - an agreement for when interests are not enjoined in the payment of penalty in case of non-compliance. Therefore, both are different and can be demandable distinctively

3. Penalty, damages and interests enforceable - 

The creditor can recover damages and interests:

1. When stipulated by the parties;

2. When the debtor refuses to pay the penalty; or 

3. When there is guilty of fraud in the obligation as per the obligor’s fulfillment.

Requirement to make penalty enforceable - the penalty can only be enforced when it is demandable only if there is a breach of the obligations which are in accordance with the provisions of the Civil Code ( not contrary to laws, morals, good customs, public order, or public policy). If the obligation cannot be performed because of a fortuitous event the penalty is not demandable. 

• A debtor cannot evade payment of his principal obligation by choosing to pay the penalty stipulated, except when the debtor is EXPRESSLY granted with the right to substitute the penalty for the principal obligation. – an obligation with a penalty clause cannot be turned into a facultative obligation unless expressly stipulated in the contract. 

• The creditor cannot demand the stipulated fulfillment of the principal obligation and the penalty at the same time, except 

1. when the creditor was clearly given the right to enforce both the principal obligation and penalty; 

2. when the creditor has demanded fulfillment of the obligation but cannot be fulfilled due to the 

a. debtor’s fault – creditor may demand a penalty.

b. creditor’s fault – he cannot claim the penalty 

c. fortuitous event – principal obligation  

d. Fraud on the part of debtor - creditor recovers the penalty and payment for damages for non compliance.

Penalty demandable without proof of actual damages

When there is a penalty clause in a contract, all the creditor needs to prove in order to enforce the penalty is that the debtor violated the terms of the contract. It is not necessary to present evidence that proves the losses and damages the creditor has suffered or the extent of them. In fact, avoiding the need and other difficulties associated with legal proceedings is one of the reasons for fixing the penalty. 

The penalty may still be enforced by the creditor whether he suffered damages or not. But he will not be able to recover more than the stipulated penalty even if he has the ability to prove that his damages exceed the penalty.

Article 1228 only applies when the penalty is fixed by the parties in lieu of the indemnity for damages. 

When penalty may be reduced by the courts

Evident justice is the rule in Article 1229. The penalty provided for in the penal clause  may be reduced by the courts.

1. When there is partial or irregular performance.

• The first refers to the extent of fulfillment, the latter, to the manner. The penalty should be more or less proportionate with the extent of the breach of the contract or of the damage suffered.

Example: 

Jose agreed to construct the house of Maria within four months for P 1,200,000 pesos according to certain specifications. The contract stipulates that in case of noncompliance with the obligation, Jose will pay a penalty of P300,000. Except for some finishing touches, Jose practically completed the construction of the house after four months.

This is a case of partial performance. It is clearly unfair for Jose to exact the payment of the full amount of P250,000 as penalty. Since, Maria has been benefited by the partial performance the court may equitably mitigate the penalty, say to P25, 000. The penalty should be more or less proportionate with the extent of the breach of the contract or of the damage suffered.

An example of irregular performance is when Jose completed building the house but he did not do it in line with the specifications of the contract.

2. When the penalty agreed upon is iniquitous or unconscionable.

• In this case, the punishment could be lowered even in the absence of any performance. Liquidated damages, whether intended as an indemnity or a penalty, are not void even if unjust or unreasonable; rather, they can only be subject to an equitable reduction.

Example: 

Suppose in the same example, the value of the house is only P150,000. It is stipulated that for every day of delay, Jose must pay a penalty of P5,000.

If the penalty is obviously outrageous and unconscionable, as it was in this case, the court may decrease it in the exercise of its good discretion. Contracts are enforceable in accordance with their terms, but only if they fall within the limits of the law and public policy.

Effect of nullity of the penal clause

If only the penal clause is void, the principal obligation remains valid and demandable. The penal clause is just disregarded. The injured party may recover indemnity for damages in case of non-performance of the obligation as if no penalty had been stipulated. (see Art. 1170)

Example:

Anna agreed to sell beauty products to Eve. It is provided in their agreement that in case of default, Anna will deliver illegal drugs as penalty. 

Here, the obligation to sell beauty products is valid but the penalty to deliver the illegal drug is void. For failure of Anna to comply with her obligation, Eve may recover damages.

Effect of nullity of the principal obligation

If the principal obligation is void, the penal clause is likewise void. The reason is that the clause cannot stand alone without the principal obligation to which it is subordinated.

But if the nullity of the principal obligation is due to the fault of the debtor, who acted in bad faith, by reason of which the creditor suffered damages, on equitable grounds, the penalty may be enforced. (see Art. 10, 19, 20, 21)

Example: 

Anna agreed to deliver to Eve 1 gram of illegal drugs. The contract carries a penal clause to the effect that in case of noncompliance with the obligation, Anna would pay a penalty of P50,000. 

Here, the nullity of the principal obligation carries with it that of the penal clause although it is itself valid.